Whether your mutual-fund team is a winner or a disappointment, there’s always room for improvement.
And just like in the National Football League, one of the best ways to improve your squad is through better drafting.
The NFL held its annual draft recently; it’s the process by which teams select from available college athletes, taking turns choosing players they hope will contribute to a prosperous future.
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As with picking funds, there are some successes, some failures, and the quality of a pick often can’t be judged for a year or two.
Individual investors need different funds and managers to do different jobs in their portfolio; by picking those players the way a general manager considers an athlete — focusing on the same critical elements that make an athlete successful — investors can build up their offense, stiffen their defense and improve their odds of winning the game.
Here are the traits that football GMs — and investors — should consider in selecting their next player:
Position/needs. Every team needs balance, which is why coaches sometimes “draft for need.”
It’s hard to pass on the “best available player” in favor of one that plays the right position, but it’s necessary.
If your portfolio already has a few domestic large-cap funds, for example, it’s time to look for a different investment style or asset class.
It’s tough to gain ground with five offensive linemen but no running backs.
Speed. The pros evaluate “straight-line speed” versus “football speed,” which is how a guy maneuvers in traffic.
In funds, this is about the fund’s asset class and strategy relative to peers.
There are, for example, aggressive-growth funds that shoot for maximum returns and others that thrive on consistency; there are funds that promise average returns, but with limited volatility.
You must evaluate how (and how quickly) a fund can get you from today to your financial goal line.
Size. The fund industry can’t settle longstanding arguments on whether a fund’s size consistently affects returns, but the general feeling is that fast-growing or already-gigantic funds tend to provide middle-of-the-road performance.
There’s nothing wrong with that; it’s the fund equivalent of big, bulky offensive linemen doing the grunt work.
Behind those building blocks, however, you may want smaller, more-nimble funds that are trying to make the big play.
Depending on the role you envision for your next fund, size matters.
Attitude. Your players must fit your system and mindset; their investment style has to mesh with yours.
If you are a defensive-minded coach, preferring to protect assets rather than shoot for the biggest scores possible, you want funds that fit your thinking.
Background. Coaches worry about the level of competition a player has faced, whether it was at a football factory or a tiny unknown college.
In mutual funds, it’s past performance.
Players from good backgrounds sometimes falter, but the odds of making a mistake increase if you pick from unproven territory, specifically a fund or manager with limited experience.
Workouts/scouting service reports. The pros test, prod, and research players themselves, but they also rely on scouting services, firms that rate the quality of the athletes.
Fund investors have Morningstar, Lipper and others; when independent research confirms your feelings, you’re more comfortable making the pick.
Longevity. Some athletes are a flash in the pan, whose style gives them a great season or two before they burn out.
Others perform in a way — or play a position — in which they can last for a decade or more. The same goes for funds. The bulk of your money belongs in issues that you can imagine owning for many years.
There’s nothing wrong with using a hot issue or two to run up the score, but unless a fund can fit your needs for the foreseeable future, it probably doesn’t belong on your team.
Smarts. Fundamentally sound players typically avoid penalties.
You pay the price when a fund has high expenses and other fees.
You also lose investment yardage in a fund that tends to pay out big capital gains, because you get a heavy tax bill that could have been avoided by choosing a more tax-savvy peer.
Time. It takes a few years to evaluate winners and losers in a draft.
Give your picks time to prove they belong, but remember that good scouting doesn’t always pay off; about half of the top picks in the NFL draft will be busts.
If you get to a point where you feel certain you made a mistake in drafting the fund in the first place — if you evaluate it in the future and know that you would not buy all over again — cut the fund and move on.
Too often, investors fall in love with a fund’s potential, story or history, and stick around way too long hoping for a return to break even; their portfolio would recover more quickly if they gave up and moved on.
Good general managers aren’t afraid to admit their mistakes and move on from them; good investors know that what happens next is what matters most.
Chuck Jaffe is senior columnist for MarketWatch. He can be reached at email@example.com or at P.O. Box 70, Cohasset, MA 02025-0070.
Copyright, 2013, MarketWatch